Sunday, December 8, 2013

My issue with the Anat R. Admati, Peter M. de Marzo, Martin Hellwig and Paul Pfleiderer, October 2013, paper.

The authors referenced have published a revised paper titled “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive”. I agree with much… except for…

The author states on page 9: “Another issue we do not elaborate on here is the current use of risk weights to determine the size of asset base against which equity is measured. As discussed in Brealey (2006) Hellwig 2010, and Admati and Hellwig (2013) this system is complex, easily manipulated and it can lead to distortions in the lending and investment decisions of banks.”

And that issue is too important to be set aside in the context of any discussion of bank equity, and what is said also leaves dangerous space for doubts. I have argued for years that risk weights, which effectively determine the capital requirements for banks against different exposures, even if not manipulated, do distort the allocation of bank credit in the real economy... and there should be no doubts about that.

If there is anything that with respect to the banking system has put our western economies on a downward slippery slope, that is not so much the problem of banks having too low capital requirements, but the issue of allowing banks to earn much much higher risk-adjusted returns on their equity on what is perceived as “absolutely safe”, than on what is perceived as “risky”. 

That guarantees the dangerous overpopulation of the “absolute safe havens”, and that the “risky-bays” our economies need to be visited in order to move forward… will be dangerously underexplored.

“The Infallible”, those with extremely low risk weights, 20% or less, comprise the infallible sovereigns, the AAAristocracy and the housing sector.

“The Risky”, those with 100% or higher risk weights, count among its ranks, medium and small businesses, entrepreneurs and start-ups.

That has made it more profitable for the banking sector, on risk adjusted terms, for instance to finance the houses where we are to live in, than to finance the job creation that will allow us to pay for the utilities.

That has made it more profitable for the banking sector, on risk adjusted terms, for instance to finance the King Johns of the world, than to finance the Robin Hoods and their friends.

The regulator (the neo-Sheriff of Nottingham) amazingly ignored (unless it was on purpose) that the ex ante perceived risks he considers in order to define the capital required (the denominator), are cleared for by banks and markets by means of interest rates, size of exposure, duration and other terms (the numerator). 

And so the regulator screwed up the whole risk price equation and caused banks to overdose on perceived risks… and funnily, if not so tragic, some still call all this a market failure 

The regulator, amazingly, instead of analyzing as a regulator why banks fail, analyzed, like if he was a banker, why the clients of the banks fail… and that, of course…c’est pas la meme chose.

On page 59 the authors write: “The use of risk-weighted assets for capital regulation is based on the idea that the riskiness of the asset should in principle guide regulators on how much of an equity cushion they should require” 

And that is precisely what is so nutty with the whole concept. The risk for the regulator is the bank, not its assets, and the prime risk for the bank is getting the risk-weights wrong.

In fact, for the regulators to really cover their real risk, capital requirements for banks should be higher for what is perceived as “absolutely safe” than for what is perceived as risky.

And, amazingly, the academic world, basically keeps mum on this almost criminal regulatory failure.

Please, can someone of you help to explain it all to the finance ministers around the world, to Congressmen, to all those who, naturally, do not understand one iota of the Basel Committee’s mumbo-jumbo